Understanding Interest-Only Mortgages

It goes without saying that historically, you can’t escape paying interest if you are borrowing money from any bank or lending institution. Maybe a close friend will lend someone money and only expect the same amount in return, but that simply isn’t how professional finance works. Sure, there are loans nowadays that allow borrowers to postpone payment of interest for a fixed period of time and solely focus on whittling down the principal, but even those loans are few and far in between when it comes to mortgages.

One unusual approach to interest payments is the interest-only mortgage. Despite how the name sounds, you still have to pay the principal back. But with an interest-only mortgage, you get a fixed time period to make interest-only payments, which are significantly lower than having the principal and interest combined.

Interest-only Mortgage Basics

Interest-only mortgages are a bit infamous in the home finance industry. A while back, early versions of the interest-only home loan were quite popular, until they sort of took a ton of blame for the large influx of foreclosures that followed in their wake. It turns out that home buyers were so entranced by the amazing initial period of low monthly payments, that when the interest-only period ended, tons of borrowers realized that they couldn’t actually afford their mortgages.

While the general formula behind the interest-only mortgage hasn’t changed much, today’s versions have safeguards and are much less risky for your finances. Although, a lot of that comes from more transparency in the modern mortgage transaction. Interest-only mortgages aren’t for everyone, and can be a little complicated, but they do have their purpose in home finance.

How Interest-Only Mortgages Work

Interest-only mortgages are home loans with a unique payment structure. Unlike traditional mortgages where payments are amortized, meaning split between principal and interest, an interest only mortgage has a fixed period where the only thing that you have to pay for is the interest. The structure isn’t entirely unlike hybrid adjustable rate mortgage packages, where borrowers have a period of time where the interest rate is fixed, before becoming adjustable and fluctuating with the market.

Of course, with an interest-only home loan, that period is solely for paying interest, however long it may be. Your monthly payments wouldn’t start reducing the principal amount until after the initial period has ended. At that point, depending on the type of interest-only mortgage you have, your monthly payments will look wildly different, or you may even end up facing a large balloon payment.

Are Rates for Interest-Only Mortgages Fixed or Adjustable?

Surprisingly, interest-only mortgages can be either adjustable rate or fixed rate. Unsurprisingly, the fixed rate version seems to be the more popular choice, with the flagship interest-only loan product being a variation of the 30-year fixed rate mortgage.

Initial interest-only periods on these mortgages can last anywhere from 5 to 10 years.The most common interest-only mortgage product has a fixed rate over a 30-year loan term, but the first ten years make up the interest-only portion of the loan.

It is important to note that during the initial period, it is possible to make payments towards the principal amount. However, your ability to do so depends wholly on the loan agreement and the stipulations set by the lender. While it is rarely forbidden to pay some principle during the initial period, some lenders may not allow it. Although more than likely, you’ll just be charged a prepayment penalty fee, which is actually more than enough to keep borrowers from attempting to pay towards their principal balances during that time.

Interest-Only Loan Products

We mentioned earlier that interest-only mortgages exist in many forms. While we briefly spoke on the 30-year FRM variation, there are many more types on the market. Some popular Interest-only loan packages include (but are not limited to):

30-Year Fixed Rate

40-Year Fixed Rate

5/1 Adjustable Rate

7/1 Adjustable Rate

10/1 Adjustable Rate

These loan packages each have options on the length of the interest only period, which typically lasts anywhere from 5-10 years.

Payment of an Interest-Only Mortgage

Interest-only mortgages are sought out for their unique payment structure that allows borrowers to have significantly reduced monthly mortgage payments. Unbeknownst to many, there is more than one method of paying off this type of home loan. Even the initial period when borrowers are supposed to make payments towards only interest is subject to differences between loan agreements. In some cases, making only interest payments is just an option that the borrower has during the initial payment period.

The first and most common approach to payment of an interest-only mortgage involves the initial interest-only period, after which the loan amortizes normally. This means that after the interest-only portion of the loan term ends, the payments will include principal and interest, to be paid over the remainder of the loan term.

Remember that the principal is usually untouched by this point, so the payments are significantly larger than during the initial payment period, and often times even larger than what the monthly payment would have been if the loan was amortized from the beginning.

The less common interest-only payment structure takes a little more courage to pull off. You see, there are interest only loans that come standard with a balloon payment that is agreed upon between the lender and borrower. In the most common cases of this variation, the interest only payment option is available to the borrower throughout the life of the loan, with the remainder of the principal balance due at the very end.

The principal amount to be paid at the end depends on how much principal the borrower chose to pay during the interest-only period. Of course, there a few versions of this with less drastic terms, and smaller (but still pretty big) balloon payments.

Entering into an interest-only mortgage means discussing these options with your lender, and figuring out what works best for you. Especially if there is a looming balloon payment to look forward to.

Who is the Ideal Borrower for an Interest Only Loan?

There is a lot to consider when thinking about an interest-only mortgage. To be fair, they aren’t as popular as many other home loan options available, and there is good reason for that. First and foremost, interest-only home loans aren’t for everyone. They can be quite expensive in more ways than one. The defining factor is how to handle the significant monthly payment increase after the interest-only period ends.

People tend to get an interest only mortgage for the sake of the low monthly mortgage payments during the initial interest-only period. Much like with adjustable rate mortgages, however, a good portion of these borrowers also refinance their home loan before having their payments increase at the end of that fixed period.

In that respect, an ideal borrower must be ready and willing to refinance their home loan before their interest-only period expires, or conversely be prepared to make significantly higher monthly payments. Providing you are able to do one of the two aforementioned actions, interest-only home loans are perfect for home buyers who would like to invest money elsewhere, but are still looking to purchase a home.

Some folks use them to purchase more expensive homes than they would typically be able to afford when they know they will have an increase of income in the future. They are also perfect for investors who rent properties out.

Though not a common practice, interest-only mortgages work well for first time home buyers, who could use the lowest possible monthly payments available to them. However, because the principal is left untouched, it is not recommended for first time borrowers unless they are absolutely sure they know what they are getting themselves into. Interest-only mortgages are not the best loan for people looking to settle down and build equity.

Lastly, another group that benefits from interest-only mortgages are those who have variable income, like commission earners. Having the option to make interest-only payments allows borrowers to breathe easy during their low income periods. When they make more money, depending on the loan agreement, they can always use some to pay some of the principal down if they so choose.

Qualifying for an Interest-Only Mortgage

We previously mentioned the horror stories of interest-only mortgages of the past to highlight the risk involved for potential borrowers. The reason it is a much safer loan now than it was back then is because instead of qualifying based on your ability to make the interest only payments, now, borrowers must qualify based on their ability to pay the highest possible payments they may be responsible for after the set period allowing interest-only payments ends.

Besides that, eligibility requirements for interest-only mortgages vary from lender to lender. The most important thing to keep in mind is that your financial profile will be heavily scrutinized. This means that lenders will have requirements for your credit score (many won’t accept any borrower with a score under 700), your debt to income ratio, your current income, your monthly debt obligations, etc. Many will even have specific down payment requirements.

The only thing that remains consistent among interest-only loan programs on the market is that 9 times out of 10, they are much harder to qualify for than traditional mortgages.

Benefits of an Interest-Only Mortgage

For home buyers looking for some savings on their monthly mortgage payments, the interest-only home loan is a pretty strong option. Having the option to pay only interest for a fixed period of time can truly help a homeowner save some money or invest money without breaking the bank.

Interest only loans are also a great way for borrowers to buy a more expensive home, and pay less each month than they would through a traditional mortgage. Buyers have the entirety of the initial payment period (which can last anywhere from 5 - 10 years, depending on the loan agreement) to save money and enjoy the low monthly payments. After the period is up, they can refinance if they are unable to make the larger payments that include principal.

They are also an extremely attractive option for those with income that isn’t set. It is one of the few loan options on the market with a period of substantially lower monthly payments. Borrowers just have to keep an eye on the maturity date of the initial payment period, and make payments towards the principal whenever they can afford to do so, if their lender permits it.

Drawbacks of an Interest-Only Loan

A period of incredibly low monthly mortgage payments would be appealing to anyone who has had a mortgage before. While that is exactly what is offered with an interest-only mortgage, they are not without drawbacks. The most glaring problem being that once the interest only period ends, there will be significantly higher monthly mortgage payments to make, or worse, a balloon payment.

Worrying about making these payments is one thing, but that's not where the drawbacks end. Another significant drawback is that borrowers will not be building their home equity anywhere near the normal rate, if at all. To truly reap the benefits of an interest-only mortgage means to completely leave the principal untouched. That means having zero equity after making payments for a period that could be up to ten years long!

Still, the greatest risk comes from that exact situation unfolding, combined with a decrease in the property’s value. This would leave a borrower owing an exorbitant amount of money for a property worth less than what is owed. To make matters worse, the monthly payments after the set period will be higher than what they would have been with a traditional mortgage loan.

Interest-Only Mortgages: In Review

If you’re a borrower with an income that will increase as time goes by, and are looking to buy a home while enjoying low monthly mortgage payments, then the interest-only mortgage is worth considering. Interest only mortgages allow a set period of time where you can make payments of solely interest, leaving the principal out of the equation until the period ends.

A cautious borrower is best with this loan type, as there are a few pitfalls that can cause big trouble if they aren’t planned for. After the interest-only period expires, borrowers will be faced with substantially larger monthly mortgage payments. Some may even face a hefty balloon payment.

All things considered, interest-only mortgages may be horrible for growing equity, but they are a great solution for home buyers looking to utilize more of their money for other things when purchasing a home. If you’d like to find out if an interest-only mortgage will work for you, don’t hesitate to give us a call and speak with a home.loans mortgage expert.

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